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Explain the Modigliani–Miller propositions concerning capital structure, including the impact of leverage, taxes, financial distress, agency costs, and asymmetric information on a company’s cost of equity, cost of capital, and optimal capital structure.

Explain the target capital structure and why actual capital structure may fluctuate around the target.

Describe the role of debt ratings in capital structure policy.

Explain factors an analyst should consider in evaluating the impact of capital structure policy on valuation.

Describe international differences in financial leverage and their implications for investment analysis.

SUMMARY OVERVIEW

The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital).

In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on company value.

The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt.

In the Modigliani and Miller propositions with and without taxes, increasing a company’s relative use of debt in the capital structure increases the risk for equity providers and, hence, ...

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